QE: Gun boat diplomacy toward China's currency

U.S. and Japanese central bank quantitative easing programs are placing China between a rock and a hard place in which a revaluation of the Chinese yuan vs. the U.S. dollar may turn out to be the least bad solution from the point of view of China's leadership.

If that turns out to be the case, it would be seen as an important victory for the U.S. and Japan. QE would have scored where hardnosed negotiations so often failed. It would also set a worrying precedent in which QE is no longer just viewed as a means for economic stimulus, but also as a weapon. Possibly one far cheaper and more effective than gunboats.

For millennia China's rulers have been deeply preoccupied with unemployment and inflation, which have the potential to cause popular unrest and un-seat rulers. Even the departing Premier Wen Jiabao recently warned that keeping prices in check would remain a key challenge for the country's policy makers.

China holds a dim view of the U.S. Federal Reserve's money creation programs because they are causing commodity prices to rise and are fuelling hot money flows into countries not pursuing easy money policies, such as China. With the Bank of Japan promising to be every bit as aggressive as the Fed, there is likely to be even greater pressure on China's inflation.

With inflation looking like more of a threat to China than unemployment at the moment, China may have no other choice than to revalue CNY upwards vs. USD.

China's consumer prices registered a 10-month high in February of 3.2% year-on-year, but more seriously in terms of popular discontent potential, food prices rose 6%. That's partly down to China's New Year festivities. But flows of speculative capital driven by foreign central bank QE programs could see China's inflation levels pushing higher.

The magnet for that hot money is partly because CNY has risen in value pulled up by its USD peg. According to the People's Bank of China there was 684 billion CNY ($109 billion) worth of foreign currency exchanged in January, a record for a single month.

Large inflows of hot money can spur imbalances in China's economy as it feeds the already significant shadow banking system and speculative activity in real estate and commodities, making them more expensive for industry and households.

China could simply try and clamp down on those capital inflows and that's still a possibility. But it has porous capital controls and the authorities want China to become an international finance center and for the CNY to one day become a reserve currency. Enforcing stricter capital controls would be a retrogressive step in terms of achieving those objectives.

The downside of allowing CNY to appreciate, especially against USD, is that it will make many of China's exporters uncompetitive and that will create unemployment in the coastal cities. Also, rebalancing toward a consumer driven economy and more value added activity still has a long way to go.

Depending how a CNY revaluation was managed it could suck in even more hot money if speculators were left anticipating further appreciation. But it should make the cost of fuel and food cheaper for Chinese citizens, and therefore sustain their disposable income, which would help develop a more consumer-driven economy. At the same time a stronger CNY would make it cheaper for Chinese companies to acquire assets abroad and encourage some outflows of money.

Another important factor, the U.S. has stopped publicly accusing China of manipulating its currency. That could be an opportunity for China to review its currency peg without losing face and attribute such a move to domestic factors such as helping to control inflation.

About the Author

Justin Pugsley is the forex and gold markets analyst for New Zealand-based trading platform provider MahiFX. He is a keen student of markets, economics and history. Prior to working with MahiFX, Justin worked for a number of leading media organisations such as Thomson-Reuters and Dow Jones/Wall Street Journal.